I am not a person who uses technical analysis in analysing stocks. Even then, I found the concept of moving averages (MAs) to be very useful in understanding Oil & Gas (O&G) stocks and developing investment strategies for them. The figure below shows a typical MA chart with several MA curves using Brent crude oil price as the basis. As we all know, when the spot price moves down, the shortest duration MA curve will move down first, before the longer duration MA curves follow suit. Conversely, when the spot price moves up, the shortest duration MA will move up first, followed by longer duration MA curves.
Oil Price and Its Moving Averages |
We can assign O&G companies in different O&G sub-sectors to different MA curves. Exploration & Production (E&P) companies like KrisEnergy, which drill oil and sell in forward contracts of several months ahead, can be assigned to, say, the 2-month MA. Offshore Support Vessel (OSV) companies like EMAS Offshore, which lease OSVs to drilling contractors for charters of several years, can be assigned to, say, the 2-year MA. Ship/rig building companies like Keppel Corp, which take 2 years to build a ship and 4 years to build a rig, can be assigned to, say, the 3-year MA.
Thus, from the MA chart above, we can see that oil price has bottomed out in Jan 2016. The 2-month MA has also bottomed out not long after. This indicates that E&P companies, as represented by the 2-month MA, have started to benefit from the higher oil price. In contrast, both the 2-year and 3-year MAs are still declining. OSV companies and ship/rig building companies are still on the down trend. Moreover, comparing between the 2-year and 3-year MAs, the 2-year MA is currently lower and declining faster than the 3-year MA, indicating that OSV companies are in a worse shape than ship/rig building companies at this moment in time.
When oil price is just starting to decline, it is usually best to stick to companies on the longest duration MA as the economic impact on earnings would not be apparent until several quarters later. As an example, even though oil price has started to fall significantly since Jun 2014, concerns on Keppel Corp's earnings received maximum attention only in Jan 2016 when Sete Brasil shareholders discussed plans to file for bankruptcy.
However, when oil price begins to bottom out, it is not a bad idea to switch to companies on the shortest duration MA as the economic impact on earnings will show up there first. Longer duration MAs will still continue to fall. As an example, Interra Resources, an E&P company, reported a 34% increase in revenue in its 2Q2016 results over 1Q2016, despite seeing a 6% drop in oil production volume over the same period. In contrast, Keppel Corp saw a 12% decline in revenue and 36% decline in net profit in its Offshore & Marine (O&M) segment over the same period. Its earnings are expected to worsen in the next 2 years.
Thus, MAs provide a useful model for understanding the economics of O&G companies in various sub-sectors. However, there are several major limitations of this model. Firstly, MAs do not represent the true economic conditions of companies. Oil price will never go down to zero. Neither will MAs that track oil price. However, O&G companies can have negative earnings and become bankrupt. We have already seen several of them entering judicial management. Secondly, MA is only a technical indicator. To understand a company fully, you still need to carry out fundamental analysis. As an example, even though the revenue of E&P companies are looking up, there are significant challenges confronting individual E&P companies as explained in My Upstream Oil & Gas Rescue Operations. Likewise, even though the earnings of Keppel Corp's O&M segment are looking down, there are silver linings as discussed in Keppel Corp – A Good Captain Sailing Through Rough Waters. Thirdly, given the significant oversupply in OSVs and oil rigs, it might take longer than 2 to 3 years before the earnings of OSV and ship/rig building companies recover. In other words, it might be a 2- to 3-year MA on the way down but 4- to 6-year MA on the way up.
MAs are a useful model in understanding the economics of O&G companies and developing suitable investment strategies for them, but it is important to understand the limitations and use with care.
P.S. I am vested in Keppel Corp, KrisEnergy and Interra Resources.
P.S. I am vested in Keppel Corp, KrisEnergy and Interra Resources.